Last week, I put a huge chunk of my portfolio into AUTO. The thesis was simple: the stock was trading at a slight discount to the offered takeout price, and I viewed the takeout price as much too cheap. The odds of a higher bid seemed much too high, given the takeout price was at a multiple way below industry average and there were strong potential synergies for an acquirer. In other words: heads, I win, tails, I don’t lose.

In a similar vein, today I picked up a few shares in Outdoor Channel (OUTD). While there’s a bit more risk here, I think the thesis is pretty similar. And given that a bidding war has already started, I think the prospects for a higher bid are much, much greater.

If you’re interested, I would read the background of the merger in the proxy statement (p. 68), but basically Outdoor and Intermedia, the owner of the Sportsman Channel, have been talking merger off and on since 2007. In November 2012, the companies finally decided to merger in a transaction that valued OUTD at $8 per share. However, the package shareholders got would consist of both cash and roughly of the equity in the combined company.

I think the reasoning behind the merger is interesting (and btw, it’s the reasoning I also think CRWN will also be sold soon). Basically, the industry is merging, and there are synergies to offering cable providers multiple channels. The synergies and advantages of having multiple channels are causing single channel operators to go the way of the dodo bird.

Furthermore, we believe it will be possible to reflect additional value in our proposal once we have completed certain limited confirmatory due diligence on the company. We are confident that, given the opportunity, your stockholders will enthusiastically support our proposal

They argued they had underestimated the initial synergies between the two businesses

They argued valuation multiples had risen for the entire sector, so the stock that OUTD shareholders would be left with would be worth more than previously estimated

Finally, to bring the whole ordeal to today’s news, Kroenke delivered a definitive proposal to acquire OUTD at $8.75 with no financing or due diligence conditions. Importantly, Kroenke’s proposal has a breakup fee of only $1m compared to Intermedia’s $6.5m. For a deal with a total market value of $227m, that’s an awfully low break up fee.

So that’s the background. The question now becomes: why do I think a bidding war is likely, and what happens next?

Reading between the lines, it seems the deal Intermedia struck with Outdoor slightly undervalued Outdoor based on the huge synergies available. But that slight undervaluation has become a huge undervaluation as media multiples have skyrocketed and it’s become a true sellers market for media properties as desperate bidders with tons of cash look for more properties to reach viewers (see articles linked from my post on CRWN for more info).

Kroenke saw this and saw an opportunity: by making a superior proposal, he could force OUTD to revisit the deal. He doesn’t really want the property for himself, which is why he’s set the breakup fee so low. Instead, he wants to force Intermedia to raise their offer price or bring another suitor into play. And Kroenke only gave a week for the board to accept the new offer, which forces them to act quickly. Given the low break up fee in the Kroenke deal, the board can do so and still consider an Intermedia topping bid.

KSE’s proposal letter to OUTD asserted that the valuation in the fairness opinion delivered by Lazard Frères & Co LLC (“Lazard”) on November 15, 2012 in respect of our transaction supports their contention that the KSE Proposal is superior. However, since the delivery of the fairness opinion on November 15, 2012, multiples for comparable companies have expanded meaningfully and therefore the Lazard fairness opinion no longer reflects the current value of the IMOH transaction. Had the valuation of the stock portion of the IMOH transaction been refreshed for the impact of current multiples, we believe OUTD would have seen that the KSE Proposal lands at the bottom of the range of values for the pending transaction with IMOH. Further, we believe that the fairness opinion understated the value of synergies and when those synergies are allocated to each segment and afforded current market multiples, there is conservatively an incremental 30-40 cents per share of value. Also, our significant ongoing work on the planned integration of the three merging companies has, in our view, yielded additional potential synergies of $2–$4 million.

Thus, utilizing current multiples, the allocation of synergies to the segment with respect to which they are applicable and the most recent estimates of achievable synergies, it is clear that the KSE Proposal falls below the bottom end of the range of the pending transaction with IMOH and is nearly $2.00 below the high end of the range. Furthermore, the KSE Proposal deprives the OUTD stockholders of the significant equity upside which the combined integrated company can deliver in the future.

Remember, OUTD has a market cap, even after the Kroenke offer, of only $225m-ish. The $2-4m in extra EBITDA, given the current media multiples of ~15x EBITDA, could easily justify Intermedia raising their offer price. And Intermedia specifically mentions they feel that $8.75 is below the low range of the combined company’s value and well below the high range. As a fellow single channel operation, it seems like Intermedia needs Outdoor just as much as Outdoor needs another partner.

Are there risks here? Sure. The board could always agree that Intermedia’s original offer is superior to the $8.75 offer. But given the cash out price in Intermedia’s offer is $8 per share versus $8.75 in the new offer, that risk seems extremely low as it would expose the board to numerous lawsuits, including from Kroenke himself as a shareholder (and likely UTR, the dissenting firm mentioned earlier). The other risk is that a topping offer fails to materialize, but given shares are trading below the $8.75 offer price, it wouldn’t cause a permenant loss of capital. It would just turn this into basically a money market type investment.

So I’ve added shares. Not as many as Auto, but a nice bit. I’ll keep you posted on how this plays out.

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